TB0009 Rev.

02/12

Andrew Inkpen Michael Moffett

TNK-BP (Russia)
In July 2008, BP was embroiled in a dispute with the Russian shareholders of its TNK-BP joint venture. The Russian shareholders, a group led by billionaires Mikhail Fridman, Viktor Vekselberg, and Len Blavatnik, were demanding the removal of TNK-BP Chief Executive Robert Dudley. The Russian shareholders maintained that BP was not adequately controlling costs, and was blocking efforts to expand TNK-BP outside of Russia because that would compete with BPs own operations. They also claimed that BP was employing too many highly paid expatriates in Russia. BPs response was that the ventures main area of operation was always meant to be Russia and Ukraine. According to Dudley:
The companys corporate governance is being tested and the fate of the company is a bellwether for Russias progress in improving the way its companies are runFor five years, one of my roles has been trying to balance all the issues of shareholders. And I think the ability to keep this balance is important, and I will try to keep that balance.1

In comments made to the French newspaper, Le Monde, Russian Prime Minister Vladimir Putin said that he had warned both sides that the 50-50 structure would be problematic: You shouldnt do thisWork it out between yourselves so someone has a controlling stakeThere needs to be a bossYou see the result: Theres always friction over whos in charge.2 With events escalating, Robert Dudley and BP senior management were faced with a challenging situation. Losing its stake in TNK-BP would have serious nancial implications for BP. TNK-BP accounted for nearly onequarter of BPs oil production, and close to one-fth of its reserves. How the situation was resolved would have a lasting impact on BP and its presence in Russia. The resolution would also impact Russias overall reputation for attracting and supporting foreign investment.

BP
BP, formerly British Petroleum, was the worlds third largest oil and gas supermajor. Originally founded as the Anglo-Persian Oil Company, BP went from a public company to a British state-owned entity, and then back to being publicly traded during the Thatcher years. BP made many acquisitions over the past century, including Standard Oil of Ohio, Amoco, Castrol, Aral, and Arco. BPs upstream business operated in various countries, including the United States, the United Kingdom, Australia, Angola, Azerbaijan, Canada, Egypt, Russia, Trinidad, Tobago, and Indonesia. The company also operated a diverse range of pipeline, rening, chemical, and retail assets around the world. In recent years, the company had adopted the tagline Beyond Petroleum as way to distinguish itself from its hydrocarbon-based competitors. Like its supermajor competitors, BPs biggest challenges were increasing oil and gas production and replacing reserves. Most host governments in oil-producing nations were looking for better contractual terms, and the so-called easy oil and gas discoveries were already made. Reserve replacement and equity ownership of new
Copyright 2009 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professors Andrew Inkpen and Michael Moffett for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.

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discoveries was becoming difcult. In 2003, then-CEO John Browne told analysts that BPs daily oil production would rise 1.0 million barrels to 4.5 million barrels per day by the end of 2007. The result was less than half the projection, and targets were scaled back to 4.3 million barrels per day by 2012. In 2008, the company planned to invest $15 billion in its upstream business. Relative to its competitors, BPs production growth was constrained by its mature oil elds. Thus, BP was aggressively looking for new reserves, and the stake in TNKBP was a major part of expected production growth. BPs nancial performance in many areas was lagging behind that of ExxonMobil and Shell, especially in the rening sector, which was planning 2,000 job cuts in 2008. The company was also planning about 2,500 head-ofce job cuts to eliminate bureaucracy and restructure the organization around global businesses rather than geographic sectors. In addition, BPs safety record was under close scrutiny after a recent series of incidents, the most serious of which was the 2005 explosion at Texas City that killed 15 people.

The Oil and Gas Industry in Russia

Russia was the worlds largest natural gas producer and second largest crude oil producer. The share of oil and gas in Russias GDP was believed by many analysts to have more than doubled since 1999 (although some reports, such as a 2007 report from Alfa Bank, said the oil and gas GDP share was declining). Oil and gas revenues made up about 50 percent of Russian budget revenues, 65 percent of exports, and 30 percent of foreign direct investment. According to The Economist, The ow of petrodollars has created a sense of stability, masked economic woes, and given Russia more clout on the world stage.3 Russias proven reserves ranked number seven in the world, and there were huge opportunities for further exploration. To manage the windfall from high energy prices, the Russian government created a sovereign wealth fund that held almost $160 billion at the end of 2007. The Russian oil and gas industry was dominated by six large rms: TNK-BP, Lukoil, Gazprom, Rosneft, Surgutneftegaz, and Tatneft. The latter four were government controlled. Gazprom, with 436,000 employees, was Russias largest company, the worlds largest gas producer with about 93 percent of Russian gas production, and the dominant exporter of gas to Europe (Gazprom supplied about 25 percent of the European Unions gas). In recent years, Russia had been accused of using gas exports as a means of achieving foreign policy objectives. Gazprom had made many acquisitions of small Russian companies that had been privatized in the rigged auctions of the 1990s. Gazproms oil subsidiary, Gazprom Neft, formerly the independent company Sibneft, was Russias fth largest oil-producing company. Two oligarchs and former partners, Roman Abramovich and Boris Berezovsky, acquired Sibneft for US$100 million; in 2005, Gazprom paid $13 billion for majority control (Note: Oligarch is a term for a small group of businessmen who acquired signicant wealth and political inuence in post-Soviet Russia.) Gazprom had announced that it planned to make major oil and gas investments outside Russia. Before becoming Russias president, Dmitry Medvedev was chairman of Gazprom. Rosneft, the largest oil producer, was a remnant of the Soviet Unions Ministry of Oil and Gas. Rosneft was broken up in the early 1990s, and was left with few assets. After 2004, with the acquisition of assets from the now-defunct Yukos, Rosneft became a major rm. In 2006, Rosneft sold 15 percent of its shares in one of the worlds largest IPOs. Surgutneftegaz was believed to be closely tied to the Kremlin. The controlling shareholder of Tatneft was the Russian Republic of Tatarstan. Ownership of Lukoil, the largest nongovernment-controlled oil company, included two oligarch shareholders with a 25 percent stake, and Conoco-Philips with 20 percent. Despite the size and importance of the oil industry in Russia, all was not well. Production in 2008 was declining because of a combination of factors: (1) aging oil elds and poor maintenance; (2) a tax and regulatory regime that was increasingly viewed as conscatory by oil companies; and (3) a dearth of Russian and foreign investment in exploration and development. The future of foreign investment was unclear. In May 2008, Russias legislature approved a bill under which Gazprom and Rosneft would have exclusive rights to develop the countrys offshore reserves in the Arctic and Far East (not the Caspian). This included the Sakhalin area, where Shell was forced in 2006 to transfer majority control of the Sakhalin II project to Gazprom. In May 2008, Russian President (and soon to be Prime Minister) Putin signed into law a bill limiting foreign investment in strategic industries, including major oil and gas elds. The law prohibited companies with less than 50 percent Russian ownership from bidding for strategic elds, allowing them to participate only as minority partners. The government retained the right to make a decision to issue a license to a foreign-controlled company in special cases.
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BPs First Foray in Russia

In November 1997, BP paid $571 million to Uneximbank, one of Russias most powerful nancial and industrial groups, for a 10 percent ownership stake in Sidanco, Russias fourth biggest vertically integrated oil company. Sidanco owned three reneries and six production facilities. The deal gave BP 20 percent of the voting rights, a seat on the board, and the right to nominate chief operating and nancial ofcers in the company. The intent was that BP and Sidanco would set up a joint venture to develop and operate Russian oil discoveries. The two companies would have an equal vote in how the venture was run. John Browne, CEO of BP, described the deal as a major opportunity for BP in one of the great oil and gas provinces of the worldWe believe the time is now right and, more importantly, that we have found in Sidanco a partner with a strong, established position at the heart of Russias oil industry. Uneximbank said, The agreement signed today is of great importance, both for Sidanco and the Unexim Group, which is the controlling shareholder of Sidanco. For successful development, Sidanco needs a strategic partner with considerable experience and a leading position in the international oil business. BP is this kind of partner. In 1998, problems began to emerge with Sidancos oil-producing subsidiary, Chernogorneft, in which Sidanco held 73 percent control. Although BP thought Chernogorneft was nancially stable, oil sold to Sidanco had not been paid for, and large tax arrears had accumulated. This helped turn Chernogornefts management against its parent, Sidanco. Also, the Russian nancial crisis of 1998 undermined Uneximbank and sharply reduced oligarch Vladimir Potanins political inuence. Alfa, a rival conglomerate, became interested in Sidanco. As BP was drawn into daily management of Sidanco, Chernogornefts debts continued to rise.

Alfa Access/Renova
In December 1998, Chernogorneft was driven into bankruptcy by Tyumen Oil Company (TNK), a company held 50-50 by a group known as Alfa Access/Renova or AAR. TNK was created in 1997 from a cluster of 600 upstream and downstream companies in Russia and Ukraine acquired through various privatization auctions. AAR was a complex alliance involving three private investment companies: Russia-based Alfa Group and Renova Group, and New York-based Access Industries. Each of the investment companies was headed by an oligarch: Mikhail Maratovich Fridman, president of Alfa Group Consortium, was born in 1964 in Lvov, on the western border of Ukraine. Fridman attended Moscow Institute of Steel and Alloys, where he had his rst business ventures, including window washing, running a discotheque, and scalping Moscow theater ticketsall illegal under Soviet rule. In 1988, Fridman set up a photo cooperative, Alfa Foto, and subsequently ALFA/EKO, a commodities trading rm, which gave him the capital to establish Alfa Bank in 1991, one of Russias largest banks. He hired a Russian foreign trade minister to head up the bank. As his wealth grew, Fridman was able to acquire signicant oil interests in Russia. He was a member of a group that funded President Boris Yeltsins 1996 re-election campaign. Alfa Group, one of Russias largest privately owned nancial-industrial groups, controlled Alfa Bank, Alfa Capital, several construction material rms (cement, timber, glass), food processing businesses, and a supermarket chain. In 2008, Forbes listed Fridmans wealth as $20.8 billion, 20th richest person in the world. Viktor Vekselberg was born in 1957 in the Ukraine. He graduated from Moscow Institute of Transportation Engineering, and later went on to complete his Masters Degree and Ph.D. in mathematics. Vekselberg worked at the special design ofce of state-owned Rodless Pumps (OKB BN). He started as a technician, and eventually became research manager. Vekselberg joined the world of business in 1990. In 1993, he became Chairman of the Board of Directors of Renova Group, which became one of Russias largest investment and business development companies. Through Renova, Vekselberg orchestrated Russias rst successful hostile takeover, acquiring the Vladimir Tractor Factory in 1994. He rose to prominence after Boris Yeltsins re-election in 1996, when he started to purchase shares of oil companies, including Tyumen Oil (TNK). In 1997, he became a member of the board of directors of TNK. Vekselberg was ranked the 67th richest person in the world by Forbes magazine, with a net worth of $11.2 billion.
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 Len Blavatnik was born in Russia in 1958. After attending Moscow Institute of Transportation Engineering, he emigrated with his family to the U.S. in 1978. He received a Masters Degree in computer science from Columbia University and an MBA degree from Harvard Business School in 1989. In 1986, Blavatnik founded Access Industries, a privately held U.S.-based industrial group. After the fall of the Soviet Union, Access began making investments in Russia in industries such as oil, coal, aluminum, petrochemicals and plastics, telecommunications, media, and real estate. With his friend from university, Viktor Vekselberg, Access and Renova collaborated in various investments. Blavatnik was ranked the 113th richest person in the world by Forbes magazine with a net worth of $8.0 billion.

BP Writes Off $200 Million

In February 1999, BP wrote off $200 million of its investment in Sidanco. In November 1999, Chernogorneft was sold out of bankruptcy for $176 million dollars to TNK. BPs director for external affairs in Russia commented:
The entire bankruptcy has been subject to major manipulations. We do not consider it to be valid. In many ways, this decision has damaging implications for foreign investors. BP Amoco will be very carefully reviewing its business position in Russia in the light of these events.4

Simon Kukes, chairman of TNK, said that his company had upheld international standards of corporate governance and ethical behaviour, and stressed that the purchase had been made in a competitive auction.5 He offered BP the chance to enter a strategic alliance with him. Although TNK denied doing anything illegal, it appeared to most outside observers that the company used its political inuence and the weaknesses of Russias laws and judicial system to ensure that a succession of court cases went its way.

BP and TNK
In December 1999, TNK and BP announced an agreement under which Sidanco would regain Chernogorneft in return for TNK receiving a 25 percent stake in Sidanco. AAR, TNKs principal shareholder, would receive 25 percent plus one share in Sidanco. In exchange, TNKs shareholders would return Chernogorneft debt-free. The deal would cost TNK about $200 million, compared with $484 million paid by BP for its 10 percent stake. In 2000, after lengthy negotiations, AARs controlling shareholders replaced Unexim Group as the dominant shareholders of Sidanco. In February 2003, BP announced a major strategic alliance with the same companies with which it had battled for control of Sidanco. Under the terms of the alliance, BP and AAR would combine their interests in Russia to create the countrys third largest oil and gas business, in which both parties would each have a 50 percent stake. The new company, TNK-BP, would be made up of various assets: TNK, Sidanco, and most of BPs Russian assets. BPs Russian assets included a retail network in the Moscow region, minority stakes in Sidanco Rusia Petroleum, and several other equity investments. For its 50 percent stake, BP would pay AAR $3 billion in cash and three subsequent annual payments of $1.25 billion in BP shares. In describing the deal, BP CEO John Browne said that BP had instituted new governance mechanisms to protect the interests of all parties. He also said that changes in Russias legal system and an increasing commitment to international rules of trade convinced BP that it was time to deepen its partnership with AAR. Browne called the experience with Chernogorneft and Sidanco a key learning experience in Russia. A BP executive said, Of course, we had qualms, given the history. But sometimes you dont get the chance to choose your partners. It was the only deal available.6 When the JV was announced (see Exhibit 1), there was speculation that the Russian government had reservations about the desirability of foreign investment in energy reserves. There was also speculation that the speed with which the deal was done caught the government off guard.

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Exhibit 1. Agreement on Structure of TNK-BP Holding Signed in London

TASS, Thursday, June 26, 2003 British Petroleum and the Russian Alfa Group (Access-Renova) signed an agreement in London on Thursday, determining the structure of a deal on establishing a TNK-BP joint venture. Under the agreement, all commercial and nancial obligations of the sides are formalised, which opens a way for the nal creation of a holding. The history of the TNK-BP Company starts from this moment, said chairman of the board of directors of the Alfa Group Mikhail Fridman. Im sure that this new unique entity will play a leading role in the Russian and, later, in the world oil industry. We hope that merging trends in the Russian and world fuel and energy complex will not be limited to this deal, said, in turn, TNK board chairman Viktor Vekselberg. This deal is an international recognition of rising political stability in Russia and its progress in the economic development, he noted. Holding President Robert Dudley admitted in an interview with Tass that it was not an easy thing to take a decision on expanding BP business in Russia. The company carried out a painstaking assessment of assets over the past nine months, and spent enough time on making feasibility estimates. BP participated in a number of major deals over the past ve years, and not a single one was concluded with greater carefulness than the present one: this is true both of assets and obligations as well as legal formalities, the president said. TNK-BP will have substantial assets in the most important oil-bearing areas of Russia: production will total 800,000 barrels a day in Western Siberia, and 370,000 barrels a day in the Volga-Ural area. Besides, Dudley continued, the company will continue the development of deposits, which was already conducted. There are now 8,000 mothballed wells, he went on to say, and the company mulls over a possibility of resuming their operation gradually. It will be necessary to restart several thousands of wells annually, the president stated. British Petroleum intends to use skilled Russian personnel and to bring machinery and methods from other areas of the world to organise production so as to optimise deposits, wells, and land infrastructure to boost efciency of recovery, Dudley emphasised.

Joint Venture Structure

The joint venture was legally created in August 2003. In 2004, a major restructuring simplied the complex TNK-BP holdings (a dozen subsidiaries and hundreds of legal entities). In 2005, further restructuring occurred. Three holding companies (TNK, Sidanco, and ONAKO) were merged into TNK-BP Holding. Approximately 70 percent (by value) of minority shareholders in 14 key TNK-BP subsidiaries exchanged their shares for shares in TNK-BP Holding through the voluntary share exchange program. Upon completion of the voluntary share exchange program, minority shareholders owned approximately 5 percent of publicly held TNK-BP Holding. An independent valuation by Deloitte & Touche put a value of $18.5 billion on TNK-BP Holding. See Exhibit 2 for the ownership structure in 2008. Exhibit 2. TNK-BP Ownership Structure, 2008
Alfa, Access/Renova
50% 50%

BP

TNK-BP Ltd.
100% TNK Industrial Holdings Ltd. 100% Slavneft 100% TNK-BP Ukraine c. 50% 78% Listerine. Ukraine 75% STBP Holdings, Ltd

TNK-BP International Ltd. (BVI)

95%

63%

RUSIA Petroleum

TNK-BP Holding

Production

Refining

Marketing

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Key elements of the joint venture agreement were as follows: Ten-member board with equal representation from BP and AAR. AAR nominates the Chairman of the Board and the Chairman of the Remuneration Committee. BP nominates the Vice Chairman of the Board and Chairman of the Audience Committee. BP appoints the CEO and holds half the top management positions. The Russian shareholders have management control over government relations, legal affairs, and security. Dividends will be a minimum of 40 percent of TNK-BPs U.S. GAAP net income. The debt ratio must be kept at 25 percent to 35 percent. The business scope of TNK-BP is limited to oil and gas in Russia and Ukraine. Management is particularly focused on certain actions: to improve safety, focusing on reducing high-risk practices; to improve planning and forecasting, so that delivery can be assured and there are no surprises; to improve internal control systems and ethical conducts; to curb the chances of fraud, illegal payments, and misjudgments; to improve the reporting of results, continuously diligent and appropriate disclosure; and, nally, to increase export and production, and reduce cost through the use of better technology. TNK-BP holds a 49.8 percent interest in Slavneft through TNK-BP International Ltd. Slavneft operates as a separate entity. TNK-BP and Gazprom Neft have equal representation on the Slavneft Board of Directors. The partners are not allowed to sell their interests in the venture until after December 31, 2007 (termed the lock-in period).

BP appointed Robert Dudley as CEO. Dudley, an American and graduate of Thunderbird School of Global Management, was a veteran Amoco and BP executive. In the mid-1990s, Dudley worked for Amoco in Russia, and saw Amoco outmaneuvered on a deal by the Russian company Yukos.

Shareholder Comments about the JV Formation

At an analyst meeting in New York on October 17, 2003, BP Chairman John Browne made the following comments:
We regard this group of shareholders as one of the best in Russia, with a strong track record. Weve built a strong relationship, tested by past difficulties, notably over Sidanco. We continued to build trust, and less and less viewed each others motives with suspicion. AAR is a vital part of the future success of TNK-BP. It brings not only assets and people, but also experience and judgment on the right things to do in the Russian context. Theyve made it clear that theyre committed to making TNK-BP not only a successful operation, but a company which can compare favorably with BP in terms of the quality of governance, transparency, safety, and ethics. In these matters, I know they are reinforcing President Putins agenda for modernization. BP, as a powerful, globally connected company, brings not only technology to improve the business, but also credibility and experience in modern management. It is a partnership of mutual advantage. Finally, its about people. And weve selected some of the very best people. Whether theyve come from outside, or from TNK, or from Sidanco, or from BP.

At the same meeting, Mikhail Fridman (the lead oligarch shareholder) said:
Of course, we made quite significant profits from the deal but, frankly speaking, weve done this deal not because we just want to realize the profits, but because we do believe that the most important way for us as investors to increase our benefits and potential growth, we do believe that to create a joint venture with a company like BP at the end of the day, well benefit after all. It is obvious to everybody here that the biggest challenge we have is probably the cultural gap between the Russian style of doing business and Western style of doing business. And it is not so easy to overcome that. And from this point of view, we are quite happy that we have a long story of relationship between us and BP. And this not [sic]very smooth storynot just, you know, [sic]story of friendship and partnership that started from quite tough, you know, competitionWe do believe that there are only two things we need as a shareholder. I think its trust and, second, probably patience. 6 TB0009
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And it seems to me that both sides have enough of that. So, thats why Im quite optimistic about the future of our company.

TNK-BP Assets
In 2008, TNK-BP was Russias third largest oil and gas company in terms of liquids production, and accounted for almost 20 percent of Russias total oil production. TNK-BP employed about 65,000 people, including 85 foreign managers, many of whom had formerly worked for BP. The main oil production assets of TNK-BP were located in West Siberia and the Volga-Urals region (Exhibit 3), with new provinces being opened in East Siberia via the planned development of the Verkhnechonskoye oil eld (concurrently with the construction of the Transneft-operated East Siberia Oil Pipeline) and in the south of the Tyumen region. The main gas business assets included the Rospan project in Novy Urengoi, which is 100 percent owned by TNK-BP, and the Yugragazpererabotka gas processing joint venture with SIBUR Holding in Nizhnevartovsk. TNK-BP owned 49 percent of Yugragazpererabotka. Some specic data on TNK-BP assets are as follows: TNK-BP held approximately 200 exploration and production licenses. Twenty-seven new licenses were acquired in 2007. TNK-BPs top 10 fields delivered two-thirds of its production. Top 20 fields held 80 percent of proved reserves. Average well productivity was 15 tons per day. Approximately 25,000 km of infield gathering pipelines (following divestment of assets). TNK-BP had four refineries located in Russia (Ryazan Refinery, Saratov Refinery, Nizhnevartovsk Oil Rening Enterprize, and Krasnoleninsk Renery) and one renery in Ukraine (Lisichansknefteorgsintez), all close to production areas and export routes. The company operated approximately 1,600 retail outlets branded either as BP or TNK in Russia and Ukraine. Exhibit 3. TNK-BPs Asset Map, 2008

Source: BP.

JV Financial Results
TNK-BPs revenues, protability, assets, and cash ow had grown substantially over its brief life span (Exhibit 4; also see the various Appendices). However, the revenue structure was heavily constrained by export duties (the Russian government captured about 90 percent of crude prices), and the domestic market prices earned were complex combinations of contracts and regulated rates.
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Exhibit 4. TNK-BPs Financial Results, 2002-2007

Revenues & Profits (millions of US$)
$36,000

EBITDA/Revenue
100%

Total Revenue
$32,000 80%

$28,000

$24,000 60% $20,000

$16,000 40% $12,000 30.4% 33.7% 29.9% 25.1% $8,000

EBITDA Margin (%)

23.3% 24.5% 20%

$4,000

Net Income
0% 2002 2003 2004 2005 2006 2007

$0

Revenues grew from $9.2 billion in 2002 to $35 billion in 2007. Net income rose from $1.5 billion in 2002 (16.8 percent) to $5.7 billion in 2007 (16.1 percent). Total assets had doubled between 2002 and 2007, from $12.6 billion in 2002 to $25.3 billion. The net debt/equity ratio (debt cash / equity) decreased from 30.2 percent to almost zero in 2007 (0.1 percent). As a result, TNK-BP earned more in interest income than it paid in interest expense in 2007. Operating cash flow grew from $1.385 billion in 2002 to $5.053 billion in 2007. The growth in cash flow was deployed between both the owners and the business. Capital expenditures (capex) rose from $595 million in 2002 to $2.23 billion in 2006, with another major jump to $3.285 billion in 2007. Dividends paid grew from $139 million in 2002 to $6.664 billion in 2006 and then down to $4.379 billion in 2007. Cash and liquid assets were $2.587 billion at end-of-year 2007. The share price for TNK-BP Holding fell from a high of $3.40/share in early 2006 to $2.00/share in mid-2008.

TNK-BP Strategic and Financial Objectives

TNK-BPs strategic objective was to become a world-class oil and gas group that is an industry leader in Russia, with a clear focus on the sustainability and renewal of its resources and the efciency of its operations. The company was committed to being an integrated oil and gas company, but the partners were not in agreement as to the level of non-Russian growth. The company was also committed to growing its gas business, and was involved in various different discussions with Gazprom. The joint ventures nancial objectives were as follows: To maintain a strong balance sheet providing flexibility, liquidity, and cost-effective borrowing. To target a gearing range of 25percent to 35 percent (net debt / net debt + equity, U.S. GAAP basis). To maintain a conservative debt structure with a significant percentage of long-term debt. To maintain a dividend policy of at least 40 percent of net income. To attain an investment grade credit rating over time. To improve the timeliness and quality of financial reporting based on centralized financial management.

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In 2008, TNK-BP accounted for about one-quarter of BPs total production, one-fth of its reserves, and about one-tenth of net income.

Key Joint Venture Events 2003-2007

June 2003Uncertainty: According to Robert Dudley, TNK-BP CEO:
With all my respect for BP, it had a fairly vague idea about what is going on in Russia. It knew about Russian risks, but it had never had to deal directly with tax authorities, customs officers, monopolies, and relationships with regionsThis is more than just an oil deal. And if we fail, it will be more than just a setback for one foreign investor. It will be a setback for the whole countryand the Russian government understands that very wellWe will insist on the same level of transparency and governance as in BP.7

June 2003Russians Say the Expatriates Costs Are Too High: Victor Vekselberg commented on expatriate costs:
Bonuses and entitlement for expatriates has been one of the most hotly debated issues. Foreigners who come to Russia want to bring a piece of their own life here.8

May 2004The Russian Partners Want the Deal Changed: The Russian partners informed BP that they wanted the payments for their share of the JV to be made earlier. BP made the following statement:
We have an excellent set of agreements. We expect all partners to stick to those agreements. As we announced in February last year, BP, under the terms of the agreement, will pay three annual tranches on the anniversary of completion of dollars 1.25bn in BP shares valued at market prices prior to each annual payment. What our partners do with those agreements is a matter for them. The agreements provide for AAR to be 50 percent owners of TNK-BP through 2007.9

August 2004Yukos is Dismantled: The Russian government began the process that would see the bankruptcy and dismantling of oil company Yukos, and the jailing of its prominent and outspoken CEO, Mikhail Khodorkovsky. Yukos was charged with tax bills and other claims of about $28 billion. April 2005TNK-BP Faces a Huge Tax Bill: Russian tax authorities announced a $1 billion tax claim relating to 2001 earnings. Viktor Vekselberg said, We cannot possibly have such liabilities, and will therefore dispute themThere can be no risks, no parallels with Yukos.10 A few months later, the tax liability was reduced. Robert Dudley made the following comments:
The significance of this (tax claim) goes far beyond our company. Everyone will watch this as a test of whether Russia can integrate with the world economy. I dont think it is in the interest of the Russian government to destroy TNK-BP. Russia is inadvertently becoming increasingly difficult to navigate for well-intentioned investorsRussian and foreign alike. The state has progressively asserted its influence over the commanding heights of the economy, and state-owned companies have begun to play an increasingly prominent role. At the time when Russias economy is in need of knowledge and management skills, it is becoming increasingly difficult to bring in managers and executives.11

April 2005TNK-BP May Not Be Allowed to Bid for New Oil Fields: A senior ofcial in the Natural Resources Ministry said that that an auction for three major elds had been canceled in March in order to exclude TNK-BP. Later in the month, Vladimir Putin told John Browne, BP CEO, We were not mistaken when we supported your decision two years ago. The prots of the joint company have increased 20 times over. This is proof of the quality of management.12 October 2005Foreign Oil Companies Cannot Participate in Auctions: Russias natural resources minister announced that companies more than 50 percent foreign-owned will not be allowed to take part in 2006 auctions for new oil elds.
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March 2006TNK-BP in Major Dispute Over Gas Field: One of TNK-BPs most valuable assets was the Kovykta gas eld in eastern Siberia. The license to develop Kovykta was held by Rusia Petroleum, 62.89 percent owned by TNK-BP, and previously controlled by Sidanco. TNK-BP wanted to develop the gas for Asian markets, and Gazprom (the Russian government-owned natural gas company) said the gas should be developed for Russia. There was speculation that Rusia Petroleums license for the eld would be revoked. The Natural Resources Ministry accused TNK-BP of producing too little gas at the eld. TNK-BP argued it could not produce the 9 billion cubic meters per year stipulated in the license since Gazprom had blocked construction of a pipeline to China, and local demand was insufcient. TNK-BP had been lobbying for years for the license to be amended. October 2006Robert Dudley Says TNK-BP Will Survive:
We are confident there is a solid future for TNK-BP. Much has been written about the consolidation of the stateBut I believe having companies like this is a good thing for the industryAs long as we continue to get good results, I think the company will more than survive, I think it will thrive. I have seen no evidence that they [the Russian partners] are working to sell their interest.13

An oil industry analyst had the following observation:

BP has found it is not only dancing with the wrong partner, but that the dance tune has changed, too. They got in at a good price, and they got in at a good time. Its better for the company to adjust rather than try to go against the tide.14

October 2006TNK-BP Engineer Killed: The chief engineer for Rusia Petroleum, which held the license to develop the Kovykta gas eld, was shot dead in Siberia. Rumors about a contract killing immediately began circulating. June 2007Putin Angry about the Kovykta Gas Field Dispute: In Germany for a G8 meeting, Putin said to reporters:
How long should we tolerate it if participants of that consortium do nothing to implement the license? This is not about BP, not about the foreign partner, but about all the shareholders that took the obligations to develop this field and, unfortunately, didnt meet the license termsI wont even talk now about how the license was purchased. Lets leave this up to the conscience of those who did it a while ago, also in the early 1990s.15

Late June 2007TNK-BP Sells Its Stake in the Kovykta Gas Field: TNK-BP sold its 62.89 percent stake in Rusia Petroleum, which holds Kovyktas development license, to Gazprom for about $800 million, less than a third of its real value, according to some analysts. TNK-BP had invested about $450 million in developing the eld. TNK-BP had the option to buy back 25 percent of the eld at market price. Gazprom Approaches BP about a Deal in 2007: In mid-2007, Gazprom initiated discussions with BP about a possible alliance. Gazproms goal of becoming a global oil and gas company was being stymied by opposition from Western governments. Gazprom was interested in stakes in BP assets outside Russia. In return, Gazprom would contribute large stakes in its Russian oil business. A key element of the alliance would involve Gazprom buying AARs TNK-BP stake, which would then allow BP and Gazprom to combine their various Russian oil assets and create the largest Russian oil producer.16 Gazprom ofcials told BP privately that they believed AAR would sell. AAR said publicly that they had no intention of selling. BPs country manager for Russia, James Dupree, handled most of the discussions with Gazprom. BP CEO Tony Hayward made several trips to Russia to meet with Gazprom CEO Alexei Miller. Based on the many meetings that were held, BP was condent that a deal would happen, and that the TNK-BP partner issues would be resolved.

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2008: Can the JV Survive?

On March 19, 2008, Russian security services raided TNK-BP ofces and detained an employee, Ilya Zaslavsky, on charges of espionage. On March 21, Russias environmental agency announced an investigation of TNK-BPs largest oileld. The investigation was to be led by the same ofcial that investigated the Sakhalin II project operated by Shell. Shell was later forced to sell a stake in the project to Gazprom. On March 25, the Interior Ministry said it was investigating a $40 million tax evasion case against Sidanco, a former TNK-BP subsidiary.

Expatriates Visa Problems for BP

President Putin had complained about the dearth of Russians in top management positions in natural resource companies. In early 2008, BP had problems renewing visas for expatriate employees, allegedly because of a lack of clarity. In May, a Siberian court refused to allow visas for 148 technology specialists seconded from BP. The court order was initiated by a Moscow brokerage, ZAO Tetlis, that owned a small stake in a publicly traded unit of TNK-BP, and alleged that the fees TNK-BP paid for the BP specialists amounted to an illegal dividend for BP. BP maintained that without the specialists, TNK-BPs production could be reduced. When the expatriates, already in the country, showed up for work, TNK-BP security refused to let them enter the ofce. Robert Dudley blamed a TNK-BP executive, German Khan (a billionaire investor and colleague of Mikhail Fridman), for orchestrating the visa issue, and sought his and two other executives ouster from the venture for gross insubordination. BP said that Khan ignored instructions and applied for fewer than half the required visas. The Russian shareholders responded with a statement saying that TNK-BP should be allowed to expand outside Russia even if it would compete with BPs own operations, and called for reducing the ventures reliance on foreign specialists. The statement also called Dudleys recent comments about the visa issue deeply inappropriate.17 In July, immigration authorities approved only 71 visas, far fewer than the 150 BP requested. BP reassigned the 148 seconded employees to other BP units

The Gazprom Deal Collapses

Despite the various problems, BP remained hopeful that a deal with Gazprom would be worked out. In April, BP CEO Tony Hayward visited Igor Sechin, a powerful Putin condant and chairman of Rosneft (the following month, Sechin was promoted to deputy prime minister in charge of the energy industry). At the meeting, Hayward discussed BPs efforts to reach a deal with Gazprom. Sechin explained that Gazprom was not always able to deliver on its ambitions for making major international deals. In May, Hayward met with a former Kremlin ofcial who informed him that his talks with Gazprom were indecent and that BP should be less confrontational with AAR. Hayward was also told that the Kremlin would not force AAR to sell. On May 14, Hayward met Gazprom ofcials in Manchester, England, at a football match. At this meeting, Gazprom was noncommittal and, in a surprise to BP, suggested holding off on any decisions for a month or so.

Partner Disagreements over JV Strategy

In late May, the stakes escalated when the three Russian oligarchs met with Tony Hayward and demanded that Robert Dudley be removed as TNK-BP CEO. According to a statement released by the Russian shareholders, Dudley was favoring BP over the Russian shareholders. A spokesperson for the Russians said, He [Dudley] is acting in the interests of only 50 percent of the shareholders. We want someone who will pursue the interests of all shareholders, not just run TNK-BP like a BP subsidiary.18 The Russian shareholders were particularly upset with Dudleys ve-year strategic plan forecasting lower shareholder returns in the coming years because of high taxes, increasing costs, and stagnant production. The Russian shareholders refused to approve the plan. They argued that Dudley was too focused on increasing reserves, and should be increasing the production of existing oil elds. They wanted the 2008 investment plan of $4.4 billion cut by $900 million and the money paid as dividends. BP argued that TNK-BP was the best performing oil company in Russia. According to Mikhail Fridman:
Theres a strategic conflict of interests between TNK-BP and BP itself. We had a company that was strong, energetic, and aggressive in the good sense of the word. BP turned it into a typical bureaucracyWe dont plan to leave, and I dont think that they plan to leave. So, ultimately, were destined to come to some agreement.19 TB0009 11
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The attempt to portray this conflict as a dispute between a respectable Western company and some Russian oligarchs who are trying to take control using dirty methods is completely cynical. It is our partners who are using methods from the 1990s. There is a good English word: arrogance We sensed this condescending attitude towards what we were saying [for months]This is about the type of foreign investors Russia needs. We dont need foreign investors who limit the development of the company.20

Hayward refused to remove Dudley. The Russian shareholders threatened legal action to strip BP-appointed directors of their powers. BP was contemplating its own lawsuit against the partners to recover a portion of back taxes that were recently paid. BP maintained that the taxes paid for the period prior to the formation of the JV should be borne entirely by the previous owners of TNK (which would include Fridman, Vekselberg, and Blavatnik) and its subsidiaries, and not BP. BP Chairman Peter Sutherland expressed his frustration:
This is just a return to the corporate raiding activities that were prevalent in Russia in the 1990s. Prime minister has referred to these tactics as relics of the 1990s but, unfortunately, our partners continue to use them, and the leaders of the country seem unwilling or unable to step in and stop them. This is bad for us, bad for the company and, of course, very bad for Russia.21

The Alfa Playbook

BP took several steps to deal with its partners. In early June, Tony Hayward met with Igor Sechin to discuss AARs pressure tactics. BP moved Lamar McCay, an executive with Russia experience, from the U.S. to Russia to be Executive Vice President of TNK-BP. BP hired a consulting rm to study other foreign joint ventures involving AAR companies. The outcome of the study became known in BP as the Alfa Playbook.22 BP learned, for example, that other Alfa joint ventures had run into various difculties. For example, Altimo, an Alfa subsidiary, had a joint venture with Norways Telenor A/S. In 2007, Telenor accused Altimo of dirty tricks in the midst of a business dispute over a Ukrainian mobile phone company. Telenor accused Alfa of paying journalists in Ukraine to publish negative articles about Telenor. Altimo led a lawsuit in Ukraine and received a favorable ruling. Telenor was never informed that the lawsuit was under way. The result of the lawsuit was sent to a Telenor address that was unoccupied, and by the time Telenor learned of the ruling, the Ukrainian judge on the case had disappeared (the day after giving the decision), and it was too late to appeal. According to BP ofcials, the Alfa Playbook was playing out to the letter in the TNK-BP dispute.

BPs Options
In late July 2008, it was looking increasingly likely that Robert Dudley would not be granted a visa and would have to leave Russia. There was also concern that Russias Federal Labor and Employment Service would try to prosecute a group of TNK-BP managers for violating labor law. Because of the uncertainty, Dudley had not left Russia since March. The Russian partners maintained that his contract expired at the end of 2007, while BP said his contract was automatically renewed. In an interview, Dudley said:
Running the company now is like driving a car, and sometimes the brakes work and sometimes they dont. I spend a lot of time holding meetings out on the balcony of my office.Its not me personally, it cant be performance; its the role, the check and balance between the interests of the shareholders. Ive got an obligation to hold the line for both sets of shareholders.23

Without a Gazprom deal to buy out AAR, Robert Dudley and his BP colleagues considered their other options. One option was to take the dispute to the highest levels in the Russian government, perhaps even to Putin himself. The results of earlier meetings with Igor Sechin, Deputy Prime Minister, suggested that this option would have limited value. A second option was to seek British government help, which had been offered. Prime Minister Gordon Brown was going to be in Russia in July for meetings with President Medvedev. A third option was legal action against AAR for violating the shareholder agreement. Finally, BP could sit tight, continue to run the business, and resist the Russian shareholders. Meanwhile, the Russian shareholders continued to push for Dudleys dismissal, with Victor Vekselberg calling for a July board meeting to discuss Dudleys infringement of Russian employment, immigration, and tax laws. Although BP said Dudley would keep his job, it was hard too see how he could remain CEO if he was outside Russia.
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Notes
G. White, BP in RussiaPlagued From Start? Putin Says Venture Structured Poorly, Clear Boss Is Needed, Wall Street Journal, June 2, 2008, p. B2. 2 Ibid. 3 Trouble in the Pipeline: Russias Oil Industry, The Economist, May 10, 2008. 4 A. Jack, BP Amoco to Review its Russian Interests, Financial Times, Nov. 27, 1999, p. 15. 5 Ibid. 6 G. White, and G. Chazan, Boardroom Brawl Roils BPs Russia Venture, Talks Break Down; Kremlins Role Murky, Wall Street Journal, June 12, 2008, p. A1. 7 C. Hoyas, and A. Ostrovsky, Aiming to Clean Up in Russia with Record Deal: The Success of BPs Huge Project Will Not Only Be Judged in Oil and Money, Financial Times, June 26, 2003, p. 26 8 Ibid. 9 C. Hoyas, A. Jack, and A. Ostrovsky, Russian Partners Seek to Change BP Deal, Financial Times, May 4, 2004, p. 1. 10 I. Gorst, and A. Ostrovsky, TNK-BP Hit by a Dollars 1bn Tax Bill, Financial Times, April 12, 2005, p. 21. 11 I. Gorst, and A. Ostrovsky, TNK-BP Chief Attacks Russias Uncertain Investment Climate, Financial Times, April 13, 2005, p. 8. 12 C. Belton, Putin Allays TNK-BP Worries, Moscow Times, April 25, 2005. 13 C. Belton, Dudley Dismisses Talk of Sale, Moscow Times, October 4, 2006. 14 Ibid. 15 A. Medetsky, An Irritated President Steps into Kovykta Fray, Moscow Times, June 5, 2007. 16 G. White, and G. Chazin, Misreading the Kremlin Costs BP Control in Russia Venture, Wall Street Journal, December 16, 2008, pp. A1, A6. 17 G. White, and G. Chazan, BP Venture Is Threatened as Criticisms Spill into the Open, Wall Street Journal, May 28, 2008, p. xx. 18 G. White, and G. Chazan, Intrigue in Russia Ensnares BP Venture, Wall Street Journal, May 30, 2008, p. A1. 19 White and Chazan, Boardroom Brawl Roils BPs Russia Venture. 20 C. Belton, and E. Crooks, Fridman Accuses BP of Arrogance, Financial Times, June 17, 2008, p. 18. 21 R. Anderson, C. Belton, and E. Crooks, BP Accuses Russians of Corporate Raiding, Financial Times, June 13, 2008, p. 1. 22 G. White, and G. Chazan, BP Is in the Dark in Struggle to Save Its Russian Venture, Wall Street Journal, June 30, 2008, p. B4. 23 G. White, The Bitter Battle to Lead TNK-BP: Dudley Pushes Back as Russian Group Seeks His Ouster, Wall Street Journal, July 23, 2008, p. B1.
1

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Appendix 1. TNK-BP Holding, Consolidated Statements of Income (millions of U.S. dollars)

Sales revenue Operating expenses EBITDA EBITDA margin Depreciation & amortization EBIT Equity income Net interest income Interest expense Exchange gain / (loss) Gains on disposal of subsidiaries Prot before tax Income tax expense Minority interest Net prot Return on sales Weighted average shares (m) EPS DPS Payout ratio Export duties (part of operating expenses) 2002 $9,172 (6,381) 2,791 30.4% (580) 2,211 2003 $12,114 (8,497) 3,617 29.9% (814) 2,803 2004 $17,169 (11,390) 5,779 33.7% (1,039) 4,740 2005 $30,106 (22,536) 7,570 25.1% (1,206) 6,364 2006 $32,114 (24,684) 7,430 23.1% (1,250) 6,180 71 79 (210) (104) 2,677 8,693 (2,115) (169) $6,409 19.9% 15,448 $0.41 $0.43 105.7% 9,327 2007 $34,995 (26,399) 8,596 24.5% (1,341) 7,255 4 182 (167) 8 105 7,387 (1,453) (202) $5,732 16.4% 15,448 $0.37 $0.16 42.2% 9,256

(273) 133 2,071 (190) (337) $1,544 16.8% 15,448 $0.10 $0.01 9.0%

(177) 189 2,815 (227) (214) $2,374 19.6% 15,448 $0.15 $0.04 25.0%

(29) 4,674 (1,221) (37) $3,416 19.9% 15,448 $0.22 $0.25 112.8%

(111) 766 6,975 (1,220) (70) $5,685 18.9% 15,448 $0.37 $0.25 68.6%

Source: TNK-BP Holding, TNK-BP, and author calculations.

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Appendix 2. TNK-BP Holding, Consolidated Balance Sheet (millions of U.S. dollars)

Cash and other liquid assets Fixed assets Long term investments Other assets Total Assets Interest bearing debt Other liabilities Total Liabilities Shareholders equity Minority interest Total Liabilities & Shareholders Equity Net debt Net debt/equity Change in working capital 2002 1,083 7,751 823 2,948 12,605 3,167 2,533 5,700 5,099 1,806 12,605 2,084 30.2% (327) 2003 869 10,121 1,679 3,445 16,114 2,755 4,101 6,856 8,530 728 16,114 1,886 20.4% 661 2004 477 11,050 81 4,826 16,434 1,669 5,291 6,960 8,958 755 16,434 1,192 12.3% (499) 2005 485 11,704 90 6,609 18,888 1,811 7,844 9,655 8,606 866 18,888 1,326 14.0% (214) 2006 827 11,259 94 9,530 21,710 1,515 8,103 9,618 11488 604 21,710 688 5.6% 2,453 2007 635 13,901 20 13,348 27,904 1859 9,752 11,611 15,585 708 27,904 1224 7.8% 3,369

Source: TNK-BP Holding and author calculations.

Appendix 3. TNK-BP Holding, Cash Flow (millions of U.S. dollars)

Cash ow from operations Net capital expenditures (capex) Free cash flow Dividends paid Discretionary cash flow Net change in borrowings Equity capital raised, net Other investing/nancing activities Net cash flow
Source: TNK-BP Holding.

2002 1,980 (595) 1,385 (139) 1,246 (472) (72) 702

2003 4,082 (849) 3,233 (594) 2,639 (807) (2,111) (279)

2004 4,687 (1,293) 3,394 (3,854) (460) 580 (338) (218)

2005 5,042 (1,764) 3,278 (3,901) (623) 264 1,203 844

2006 7,877 (2,234) 5,643 (6,594) (951) (2,026) 3,319 342

2007 5,485 (3,266) 2,219 (2,420) (201) 305 (296) (192)

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Appendix 4. Public Comparables

Country P/S P/BV ROE Russia Russia Russia Russia Russia Russia Russia Russia Russia 538,994 253,141 33,667 9,752 15,409 18,363 64,736 24,295 42,498 205,892 186,271 131,370 488,394 227,019 182,004 0.73 0.92 0.80 1.36 0.64 0.83 0.88 10.03 10.25 8.66 12.28 7.22 8.61 9.51 5.94 5.68 4.98 6.91 4.33 4.33 5.36 0.83 0.58 3.48 1.11 0.54 1.31 18.85 5.30 14.91 9.96 8.73 11.55 11.15 6.29 3.66 4.37 6.37 3.16 1.72 2.85 2.00 1.51 2.25 2.20 2.49 1.58 4.12 1.81 2.52 2.45 2.61 2.29 2.54 0.47 1.98 13.77 17.58 15.77 28.43 18.89 15.07 9.83 16.94 13.95 3.08 3.39 4.07 1.20 2.94 25.81% 29.39% 29.82% 4.47% 22.37% 16.99% 24.17% 25.67% 24.50% 18.54% 21.97% 23.38% 26.04% 13.86% 35.11% 27.28% 30.95% 26.10% 17.24% 13.15% 15.33% 3.11% 12.21% 9.24% 11.16% 15.66% 11.76% 6.87% 10.94% 9.19% 13.26% 6.94% 18.49% 12.41% 12.05% 12.06% 23.21% 19.85% 23.82% 4.86% 17.94% 14.32% 21.05% 24.14% 19.69% 12.30% 18.30% 18.64% 22.56% 11.33% 33.43% 23.34% 22.81% 22.02% 305,152 64,090 27,794 38,076 13,537 29,634 9,186 86,799 23,531 3.23 1.06 1.45 1.55 0.94 1.27 0.79 2.04 9.91 2.47 12.06 8.50 7.50 10.20 10.49 4.38 3.15 7.66 34.44 10.93 9.13 5.62 5.24 0.00 5.66 0.00 3.06 11.64 21.34 6.85 1.99 1.69 2.71 0.97 1.26 2.44 0.41 3.31 7.20 2.44 21.28% 25.07% 41.63% 9.83% 13.84% 73.96% 15.09% 24.11% 22.42% 27.47% 12.70% 16.90% 29.59% 9.15% 9.90% 31.86% 10.38% 9.20% 17.27% 16.33% 16.51% 21.97% 36.09% 9.71% 13.59% 60.87% 13.94% 14.82% 20.78% 23.14% 8.89% 9.50% 10.15% 10.84% 11.30% 10.50% 9.86% 9.86% 9.86% 10.08% 17.20% 13.66% 14.09% 17.49% 15.61% 9.00% 13.13% 10.67% 12.41% 10.36% 11.11% 9.41% 10.09% 10.09% 10.03% 9.18% 10.12% 9.82% Capitalization million USD Market Multipliers P/E EV/EBITDA Financial Multipliers ROA ROIC WACC
ROIC/WACC

Company

Gazprom LUKOIL Gazprom Neft Surgutneftegas Tatneft TNK-BP Transneft Rosneft NOVATEK Russias Average

1.86 2.31 3.56 0.90 1.20 5.80 1.41 1.50 2.11 2.29 1.35 1.45 1.69 0.28 1.19 1.59 1.60 2.26 1.59 1.19 1.65 1.98 2.24 1.12 3.33 2.54 2.25 2.24

PetroChina China Petroleo Brasileiro SA Brazil Sasol RSA Sinopec China Emerging Markets Average

16 TB0009 Great USA USA USA Holland France

Purchased by: Donna Sammis DONNA.SAMMIS@STONYBROOK.EDU on February 11, 2014

Murphy Oil USA Norsk Hydro Norway Occidental Petroleum USA Petro-Canada Canada Repsol YPF Spain Developed Markets Average

BP Chevron Texaco ConocoPhillips ExxonMobil RoyalDutch Total SA Global Average

Source: Veles Capital, June 16, 2008, p. 17. Original data drawn from Bloomberg, Estimation, and Veles Capital.